Many investors are still learning about the various metrics that can be useful when analysing a stock. This article is for those who would like to learn about Return On Equity (ROE). By way of learning-by-doing, we’ll look at ROE to gain a better understanding of PepsiCo, Inc. (NASDAQ:PEP).
Over the last twelve months PepsiCo has recorded a ROE of 48%. Another way to think of that is that for every $1 worth of equity in the company, it was able to earn $0.48.
View our latest analysis for PepsiCo
How Do You Calculate Return On Equity?
The formula for return on equity is:
Return on Equity = Net Profit ÷ Shareholders’ Equity
Or for PepsiCo:
48% = 4948 ÷ US$10b (Based on the trailing twelve months to September 2018.)
Most know that net profit is the total earnings after all expenses, but the concept of shareholders’ equity is a little more complicated. It is all the money paid into the company from shareholders, plus any earnings retained. The easiest way to calculate shareholders’ equity is to subtract the company’s total liabilities from the total assets.
What Does Return On Equity Signify?
ROE measures a company’s profitability against the profit it retains, and any outside investments. The ‘return’ is the yearly profit. A higher profit will lead to a higher ROE. So, all else being equal, a high ROE is better than a low one. That means it can be interesting to compare the ROE of different companies.
Does PepsiCo Have A Good ROE?
By comparing a company’s ROE with its industry average, we can get a quick measure of how good it is. However, this method is only useful as a rough check, because companies do differ quite a bit within the same industry classification. As is clear from the image below, PepsiCo has a better ROE than the average (17%) in the Beverage industry.
That’s clearly a positive. We think a high ROE, alone, is usually enough to justify further research into a company. For example, I often check if insiders have been buying shares .
Why You Should Consider Debt When Looking At ROE
Most companies need money — from somewhere — to grow their profits. That cash can come from retained earnings, issuing new shares (equity), or debt. In the first and second cases, the ROE will reflect this use of cash for investment in the business. In the latter case, the debt used for growth will improve returns, but won’t affect the total equity. In this manner the use of debt will boost ROE, even though the core economics of the business stay the same.
Combining PepsiCo’s Debt And Its 48% Return On Equity
It appears that PepsiCo makes extensive use of debt to improve its returns, because it has a relatively high debt to equity ratio of 3.38. So although the company has an impressive ROE, that figure would be a lot lower without the use of debt.
But It’s Just One Metric
Return on equity is a useful indicator of the ability of a business to generate profits and return them to shareholders. Companies that can achieve high returns on equity without too much debt are generally of good quality. All else being equal, a higher ROE is better.
But ROE is just one piece of a bigger puzzle, since high quality businesses often trade on high multiples of earnings. It is important to consider other factors, such as future profit growth — and how much investment is required going forward. So you might want to check this FREE visualization of analyst forecasts for the company.
Of course PepsiCo may not be the best stock to buy. So you may wish to see this free collection of other companies that have high ROE and low debt.
To help readers see past the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price-sensitive company announcements.
The author is an independent contributor and at the time of publication had no position in the stocks mentioned. For errors that warrant correction please contact the editor at editorial-team@simplywallst.com.